Prepare for the Next Merger Wave

Where have all the mergers gone? For the past two years, most pundits have expected mergers to increase as U.S. corporations deploy their cash into growth opportunities.

I was one who thought we would see more merger activity by now. It just makes sense. Many sectors are still very cheap, and in the current environment it is easier to grow by acquisition than by organic expansion. The cash is on the books earning almost nothing, so buying smaller companies just seemed to make sense. Private equity and other financial firms also have a substantial cash hoard in search of returns for their investors. Yet deal flow is still anemic in 2012.

We saw some sign of a pickup in May as the dollar volume of deals increased by more than 40%, but the number of deals was pretty flat with the prior month and the year-ago period. Private-equity firms were active in the restaurant and retail sector, anticipating a recovery in the broader economy over the next couple of years that will see increased profits for companies in these consumer-sensitive sectors.

We saw some large strategic deals as well such as the merger of Eaton (ETN) and Cooper Industries (CBE) that was recently announced. Even venerable Avon Products (AVP) has attracted takeover attention, although the deal was refused by the cosmetic giant.

I never buy a company on takeover speculation. However, the pencil I use for valuing stocks is very similar to that wielded by private-equity analysts and corporate CFOs who are looking for attractive expansion opportunities. A takeover or merger is my preferred method for exiting a stock position, and this has occurred a pretty significant percentage of the time over my career. I am a big fan of shopping for stocks in industries where significant consolidation and private-equity activity can be expected over the next few years.

Small banks have been a favorite sector of mine for some time now. A combination of higher regulatory costs and lower interest margins has created a difficult operating environment for smaller community and regional banks. It makes sense to merge and achieve some economies of scale.

Many of the larger banks have loan-loss and balance-sheet problems that can be at least partially cured by buying a smaller competitor that has a super-clean balance sheet and loan book. Owning smaller banks with excess capital and low loan losses that trade below tangible book value continues to be a favorite investment approach for me in 2012. I expect to fund my sun-soaked gold years with the proceeds from my small bank investments.

No matter who ends up winning the upcoming election, we are going to see cutbacks in defense spending. The war in Iraq is pretty much over, and we are going to wind down Afghanistan over the next couple of years. The larger defense contractors will be looking for ways to grow revenue and earnings, and the best path is going to be acquisition.

I believe we will see a lot of defense money moving in the direction of reconnaissance vehicles and drones. Many of the smaller companies in that space will be attractive investments on a stand-alone basis and will also be takeover targets. I am keeping an eye on companies such as Ducommun (DCO) and Exelis (XLS), which have a presence in that market segment. My key metrics for defense companies are a combination of price-to-book and enterprise-value-to-EBITDA, and neither stock is quite there yet. I suspect they will get there as we draw closer to 2013 and the looming budget cuts.

The energy sector is going to see a lot of activity as well. Many of the drilling and services companies that have a large gas exposure were trying to sell gas-related assets and focus on oil. In yet another version of the best laid plans going astray, oil prices have been dropping of late, and this is going to pressure these companies further. There are an enormous amount of gas assets on the market right now, but once private equity has scooped up the bargains, we should start seeing companies combine to survive and grow later this year. My exposure to the sector right now is limited to EXCO Resources (XCO) and Penn Virginia (PVA), but I am starting to see significant inventory creation in this sector.

An acceleration in merger activity is a "when" not an "if" event, in my opinion. The economy is cloudy, and an uncertain election outcome may delay the merger wave, but at some point it will happen. Assets and earnings bought cheaply prior to the M&A explosion should prove to be wildly profitable for investors who take a "safe and cheap" approach.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider DCO and PVA to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.